A firm is evaluating a machine that costs $100,000 today and will generate $12,000/year for 10 years. At an 8% interest rate the project is unprofitable; at 3% it becomes profitable. What does this illustrate about the role of interest rates in investment decisions?
AHigher interest rates make future revenues larger in present-value terms, so projects become more attractive
BThe interest rate acts as a discount rate: it reduces the present value of future profits, making marginal projects viable or unviable depending on its level
CInterest rates only matter if the firm is borrowing money; firms using retained earnings are unaffected
DThe decision depends only on the total undiscounted revenue ($120,000) versus cost ($100,000), which is always profitable regardless of rates
The interest rate is the discount rate that converts future earnings into present value. A higher rate shrinks the present value of the same income stream — a $12,000 annuity is worth less at 8% than at 3%. This is why investment demand slopes downward with respect to interest rates: many marginal projects are profitable at low rates and unprofitable at high rates. Option C is wrong because even firms using retained earnings face an opportunity cost — those funds could earn the market rate of return if lent out instead.
Question 2 Multiple Choice
The interest rate enters investment decisions through two distinct channels. Which answer correctly identifies both?
AIt raises firm costs and it reduces consumer spending, both of which shrink investment
BIt acts as the discount rate on future profits AND as the opportunity cost of capital deployed in the project
CIt affects only the cost of debt financing; equity-financed firms are not affected by rate changes
DIt changes the expected level of future profits AND the current price of capital goods
The interest rate does double duty in investment analysis: (1) it is the discount rate that determines the present value of expected future revenues — a higher rate means future profits are worth less today; (2) it represents the opportunity cost of capital, since funds used to invest can't be lent at the prevailing rate. Both channels mean that higher interest rates depress investment. Option D is partially plausible but wrong: expected future profits are not determined by the interest rate, and capital goods prices are a separate input-cost variable.
Question 3 True / False
Very low interest rates guarantee an increase in business investment spending because firms' borrowing costs are reduced.
TTrue
FFalse
Answer: False
Low rates lower the cost of borrowing, but investment also depends on the expected rate of return — the numerator of the present-value calculation. If firms expect weak future demand, the projected revenue stream is small regardless of the discount rate, and investment remains depressed. This is the 'pushing on a string' problem: expansionary monetary policy can fail when pessimistic profit expectations dominate. Low rates are necessary but not sufficient for investment recovery, which is why fiscal policy (which directly affects aggregate demand and expected revenues) is sometimes needed when monetary policy alone is ineffective.
Question 4 True / False
An investment tax credit that reduces the effective cost of capital goods shifts the investment demand curve rightward, meaning more investment occurs at every interest rate level.
TTrue
FFalse
Answer: True
The investment demand curve shifts when the expected rate of return changes independently of the interest rate. A tax credit lowers the effective cost of capital — the same machine now requires less after-tax outlay — which raises the net present value of any given investment project. This makes projects that were marginally unprofitable now profitable, increasing investment at every interest rate. The curve shifts right. This is distinct from a movement along the curve (which is caused by an interest rate change), and it's why tax policy can stimulate investment even when the central bank has already lowered rates.
Question 5 Short Answer
Why is investment spending said to be especially sensitive to interest rate changes compared to, say, consumption spending? Explain the mechanism.
Think about your answer, then reveal below.
Model answer: Investment is especially sensitive because the interest rate affects it through two compounding channels simultaneously: it acts as the discount rate that converts future profits into present value, AND as the opportunity cost of deploying capital. A small rate change can flip many marginal projects from unprofitable to profitable (or vice versa), because the rate applies to every year of a multi-year income stream. Consumption, by contrast, is mostly a function of current income and is affected by rates mainly through the wealth effect and borrowing costs on durable goods — a narrower and often weaker channel.
The double role of interest rates in investment — as discount rate and as opportunity cost — means a given rate change has amplified effect relative to its impact on consumption. Moreover, investment involves committing to long-duration projects, so the discount rate effect compounds over many years of future cash flows. The sensitivity is further amplified because many firms operate near the margin of profitability on investment projects, making the rate level a threshold variable that triggers or blocks large spending decisions.